In theory, the Federal Reserve can print as much money as it likes. Reflation should be assured. Unfortunately, the wise men overlooked one small detail…wage stagnation. If consumers cannot afford to pay higher prices, you don’t get higher prices…
If you’re like 99% of the world, you expect the Fed to raise rates.
But somewhere along the way, in its perfect plan to "reflate" the American economy and prevent a Japan-style soft depression, the Fed made a fatal miscalculation: It caused a simultaneous asset bubble in stocks, bonds, commodities, housing, and real estate. We stand on the edge of the great collapse of the "reflation rally." Some assets will come through relatively unscathed. Others will deflate. What the Fed is about to reap is a lot different than what it thought it was sowing.
The Fed thought it could make money cheap and keep the stock market high (and households feeling wealthy). It was right. It thought it could keep money cheap and force savers to abandon money market funds and CDs. It was right. It thought it could keep home prices rising by keeping interest rates low (and mortgage rates low in sympathy). It was right.
It also thought it could create so much money that raw material prices would rise. It was right. The Fed’s cheap money caused a series of "flash bubbles" in the commodities sector, especially in base materials, and even in gold. It also thought it could keep money cheap and force up producer prices. Producers have to buy raw
materials, after all. It was right.
Reflation: Trying to Make Consumers Spend
And it thought that the whole chain of inflation – or the ladder, if you prefer – would be completed in the form of rising consumer prices. It thought it could prevent deflation by first forcing up raw materials prices, then producer prices, and finally consumer prices. If the Fed couldn’t make consumers borrow, it thought it could make them spend by inflating. It was wrong.
This essay is not going to be a long explanation of the failures of monetary and fiscal policy, though it would be fitting if it were. Never before has an American government been as irresponsible with its citizens’ money as the current administration. And never before has the Federal Reserve done more to undermine your standard of living than this Federal Reserve has.
The government has borrowed beyond its means and spent even more. It has made promises it can’t keep – and probably never intended to. And the Fed has encouraged the financialization of the American economy. It’s made borrowing money and using leverage so cheap that there is virtually no sense of risk in the market…risk of taking on debt…risk of buying too high…risk of the whole financial economy falling apart.
To be fair, the irresponsibility of the American government is perfectly in tune with the irresponsibility of governments everywhere. We live in an age of increased government action in the economy. Economic policies (deficit spending, tariffs, currency manipulation) are seen as the tools of economic warfare. Nations wield them against one another to gain relative advantages in a world marketplace thick with competition from numerous low-cost producers.
Reflation: Three Unique Blunders
The American government has made three unique blunders. First, it has taken the good will of the rest of the world for granted. America is a debtor nation. It depends on the rest of the world investing in America to keep the value of the dollar up. Take away investment in American stocks, bonds, and real estate, and the Great Inflation begins.
Second, our government has preached to you the benefits of globalization, namely lower prices and more choice. What they didn’t mention is that true globalization means a permanent change in the structure of the American labor market. This is how free markets work. Production moves to the lowest-cost centers. This is not a cyclical phenomenon, but a structural one: It means that America is becoming a service economy. The wages of excessive consumption are the loss of an economy that produces new investment and wealth.
Third, however, and greatest of the policy blunders is the assumption that monetary policy can cause wage inflation. Because of this error, the Fed is about to discover that its entire effort to reflate the economy through low rates has failed. And it is nearly out of interest rate bullets.
What do consumer wages have to do with monetary policy? The Fed has succeeded in causing inflation nearly everywhere in the economy EXCEPT in consumer wages. But without rising wages, consumers can’t afford to pay rising prices.
Think about it. Gas prices are high and rising. Long-term interest rates are rising, increasing the amount of discretionary income the average consumer has to pay on his adjustable rate mortgage or credit cards. Now add to those two forces rising consumer prices. What is a consumer to do? If his wages aren’t rising, can he afford higher prices, along with already high energy costs and debt service costs?
Greenspan knows that without rising wages, there can be no real "reflation." In congressional testimony that was overlooked in the press accounts, the chairman said, "Remember that more than two-thirds of the consolidated underlying domestic costs in the United States are unit labor costs…And unit labor costs, as best we can judge, are still going down."
Reflation: The End of the Consumption-Driven American Model
In other words, everything is going up in price…but consumers can’t afford to pay those prices. This, ironically, is deflationary. As prices rise, consumers cut back on spending. The more prices rise on the margins, the less consumers consume. It is nothing less than the end of the consumption-driven American model – the model the rest of the world has tolerated because Americans have been buying on credit. The credit crunch is coming.
If reflation were really going to show up in the economy, you’d see big price markups across the board in all sectors. But in a recent Financial Times article, only three big U.S. companies reported success in passing high raw materials prices on to the consumer. The companies were Ford, Honeywell, and Hormel, the company that makes SPAM. Not exactly a burst of reflation in the economy.
It must be hard for the Fed to realize this. It’s the end of the line for the reflation model. The Fed can’t cause consumer price inflation because it doesn’t control the key element of the whole inflation ladder, namely the labor market. In reality, labor market changes are a function of globalization (aided and abetted by the Fed’s cheap money policy).
The Fed has thus made it possible for a huge spike in prices, leading to the deflationary collapse of the American consumer. The normal policy response to skyrocketing inflation would be to raise rates (what the market expects). But raising rates puts the consumer in even worse shape than he is now and threatens the main source of household balance sheet wealth: the house.
If it seems to you like the Fed doesn’t have any good choices left, I agree. It’s backed itself into a monetary corner from which there is no apparent escape. It does have some options. But it will be exercising them without any historical precedent of success.
For example, the Fed may decide it wants to set long-term interest rates, too, either on the 30-year bond (which would be reintroduced) or on the 10-year bond. Granted, this would be considerably disruptive to the bond market. But in an era of government intervention, it’s just another form of price control.
More likely is that the Fed will start to "monetize" outstanding debt by buying U.S. bonds. There would probably be a lot of sellers, if it got to that. The Fed would be acting as a buyer of last resort, trading newly printed cash for U.S. bonds, which it would then own or retire. The whole goal would be getting currency in circulation, getting the consumer to spend.
That, of course, is something the Fed probably can’t do, even it wanted to. Spending is as much a psychological process as a fiscal one. People spend now when they think the future is getting better, with less risk. But when people are cautious, they spend less, they cut back, they downsize. They scale back expectations. They think differently.
It’s hard to predict what will happen to the American economy when this happens. A dollar sell-off is coming. Standards of living are going to fall. Land values will suffer, all because…
The American government was just another government that couldn’t pay its bills.
for The Daily Reckoning
May 19, 2004
P.S. I’ll be in La Jolla over July 15 and 16 for the Agora Wealth-Currencies & Resources Seminar. It’ll be a blast. John Myers, Chuck Butler, Karim Rahemtulla, Eric Roseman, and Steve Belmont are all coming down; as are many others…don’t miss it!
Editor’s Note: Dan Denning is the editor of Strategic Investment, one of the most respected "big-picture" investment newsletters on the market. A former specialist in small-cap stocks, Dan has been at the helm of Strategic Investment since 1999 – where, drawing from his network of global contacts, he has designed an investment strategy that takes into account global political and economic trends. His weekly e-mails and monthly newsletter give investors the most complete picture of what’s shaping investment markets, what’s coming next, and exactly what to do today.
Right now, Dan says your house may be the riskiest asset you own.
"I heard you had a tiff with George Gilder," wrote a friend yesterday.
Not really a tiff, we explained. We made fun of Gilder in our book. At our recent speech in Las Vegas, he politely returned the favor.
Gilder posed two interesting questions following our speech:
Why does it matter who owns America’s debt; isn’t the fact that foreigners buy our stock and bonds a sign of strength, not weakness?
Real interest rates are the same today as they were in 1982…who cares if nominal rates are only a third as high?
We gave Gilder poor answers. Here, we try to give you better ones.
Taking the first question first…Warren Buffett says the nation is getting poorer at the rate of 1% per year. The entire country – including everything – is worth about $50 trillion. The annual trade deficit of $500 billion represents a net outflow of assets of about 1%.
Buffett is right. If I go into debt to my brother, you could say that the entire family’s financial situation is unchanged. But if I go into debt to a stranger…the family’s net wealth goes down. The family is poorer.
Or, imagine a man with a machine shop. If he owns the shop himself, he is richer and more secure than if someone else owns it. If someone else owns it, he has to pay rent! Likewise, America now pays interest on the debt owned by foreigners…and rent on foreign-owned assets. The nation is poorer.
We made the point that it is unwise to lend money – long-term – at today’s low rates. Not that you won’t make money at it; it’s just that you’d have to be mad to take the bet.
Gilder wondered why. Real rates are the same today as they were in ’82, he pointed out.
But the fact that real rates of interest were the same is beside the point. A bondholder cares about nominal rates; his bonds are quoted in them. And in dollars. If he buys a bond yielding 5% today, he is making an extraordinary bet. He’s betting that the world’s financial system is 3 times as safe today as it was a quarter a century ago.
What makes it safer? The biggest explosion of dollar credits in the history of the world? The fastest growth in government debt the planet has ever seen? The proliferation of derivative contracts (to $100 trillion or more)? The highest levels of consumer debt in American history?
We don’t know if today’s bond buyer will get a whacking, but we know he deserves it.
And now, over to Tom for more news…
Tom Dyson, from the cultured Mount Vernon district of Baltimore…
– "But mainly, the crisis will be a financial one," predicts Jim Rogers, "and the responsibility for it lies with the U.S. We have allowed ourselves to go from an international creditor to a debtor nation in a matter of a few years. We are now the world’s largest debtor nation by a factor of five or six times."
– Barron’s is interviewing the Investment Biker. The date? You guessed it – October 17, 1988…sporting a natty bowtie and a satisfied grin, Rogers beams up from the page. Barron’s had caught up with him in Bombay – he was resting there after a three-month trip across China on his motorcycle. The article is titled, "Short the World – Jim Rogers is still bearish on stocks."
– "The dollar is the world’s reserve currency," warns George Soros’ ex-trading partner, "yet we have debased it with a rapidity that is unprecedented. The English pound took 50 years to collapse. All of this has created a major financial imbalance, which is going to have to be sorted out. The Federal Reserve can’t paper over the problem forever."
– Jim Rogers may have aged, but his message hasn’t – his comments seem eerily familiar. But then again, the circumstances are familiar. On the day of the interview, gold closed at $412.50. Nine months earlier, gold had been ending a three-year bull market, rising from around $300 an ounce to just over $500 by the beginning of 1988. 18 months later, gold was back at $360. $400 has been tested several times since, but 15 years on, has never really been properly breached.
– The dollar index was trading around 90…roughly where it is trading today. At the beginning of 1985, it peaked at 140. For the next 3 years or so, the Dollar dropped like a stone, losing 30% against the basket of European and Asian currencies. And just like 2003, the deficit was still growing quickly.
– Barron’s exclaims, "The trade deficit jumped to $12.18 billion in September  as a flood of imports swamped an increase in exports. The larger-than-expected deficit sent the dollar tumbling." They didn’t know it, but the deficit would become a surplus within three years, and Rogers was speaking on what might have been the night before the rally. He was wrong.
– The dollar stopped dropping. It bounced…for a while. But the laws of economics prevailed, and for the next 7 years, it zig-zagged its way down to the mid-’70s in a narrow 10-point range…a tedious, grinding bear market. And what happened next? The dollar rallied back to 110 and the current account – like a drowning man snatching his final breath – plummeted into deficit again, never looking back. It now stands over $500 billion.
– The trade deficit swelled by $46 billion in March, the greatest one-month total on record. That bombshell was released last week. As sure as night follows day, both surplus and deficit will always come back into balance. The dollar must adjust – the law states – until the balance rights itself.
– Today, the dollar index closed at 91.07, up 0.73 in the session. In Japanese terms, it’s now within 1 yen of an 8-month high. At writing, one dollar buys 113.49 yen. Versus the euro, we’re just shy of a 4-month high. The dollar closed at 1.196. Gold ran for cover, extending yesterday’s $1 loss. The shiny yellow metal closed at $375.50, down $3.70.
– Over on Wall Street, stocks gained. The Nasdaq jumped 1.13%, closing at 1,898. It may have been simply a snap back from yesterday’s downpour…or maybe not. The Dow echoed sentiment with a rally of its own…it added 62 points to close at 9,969. Unusually, the market was able to rally with rising Treasury yields, the 10-year bond adding 4 basis points to yield 4.74%.
– "The market will have to be strong or at least not weak until people sort of forget about the crash and get confident again. At that point, you can safely short stocks because, over the next year, stocks are going to be weak," Rogers bravely claims in October 1988, "any stock shorted now will pay off handsomely during the next year."
– Jim Rogers was wrong again. But 15 years later, he is considered as an investing genius. Deservedly so…the man is rich. For the big money, watch what happens when he gets it right.
Bill Bonner, back in Paris…yes, Paris!
*** The Dow bounced. But it was a dull, lifeless bounce…like a Republican struck by a beer truck.
We stick to our guess – the stock market ‘recovery’ has topped out. It’s all down hill from here – for the next 10 to 15 years.
Stocks are going down…and commodities are going up, right?
Maybe not. Look at the CRB commodities index. It, too, has a topped-out kind of look. A peaked air. A droopy posture.
Oil, of course, hits new highs every day. And gasoline is over $2 a gallon. But there’s no guarantee that the trend will continue. Higher oil prices would be consistent with a new round of inflation. Everybody says it’s coming. But we’re not so sure.
We think we hear the air escaping from the credit bubble. As it goes out, asset prices fall. And as asset prices fall, so does the ability of homeowners to refinance…and their ability to spend…and their ability to buy things that come all the way from China.
The whole economy rests on credit. What a pity to see it hissing away.
*** The Chinese, now trying to cool down their own red-hot economy, might soon wish they had some way to heat it up. And all those people who worried about runaway inflation may one day wish they could get it to leave home.
Inflation is no fun. But deflation is even less fun.
So, dear reader, don’t go out and borrow a lot of money, thinking that your debt will be wiped out by inflation. Maybe it will. But maybe you will be wiped out by deflation long before.
*** A crowd had gathered in the Houston airport. On the floor in front of the crowd was a man with a respirator, attended by paramedics.
Across the hall, at Drexler’s BBQ, the poor man got no better than even odds.
"I bet he don’t get up," said one of the hashslingers.
"I bet he does," said another.
Finally, a third member of the Drexler team came back to work, triumphantly.
"See, I told you it was a seizure."
*** We had a long layover. So, we sat down at Bubba’s Bayou Bar and Grill.
"What’s good," we asked.
"Try the Reuben; it’s our specialty."
We sat and watched the world go by. At least, the part of the world that passes through the Houston Airport.
We love America; it is so easy to feel superior here. All you have to do is put on a pair of pants.
A new fashion trend has caught on. Grown men wear huge knickers, cut off below the knees. And T-shirts. Why would a man give up his dignity without a fight? Who could take such a man seriously? Why are these men always fat? And where did such a goofy style come from?
Aha! We think we have it – this is the Fatty Arbuckle look. Of course! Imagine Fatty Arbuckle, back in style.
The Reuben sandwich was barely edible. The bread was like Styrofoam. The meat was thick, dry and tasteless.
"Why do you call this your specialty?" we wanted to know. "It’s awful."
"I don’t know. They got a lot of them in the freezer. And people seem to like them better than the Bayou Burger. Would you like to try to Bayou Burger?"
*** "So you are in Las Vegas?" begins a message from our Pittsburgh correspondent, Byron King.
"People go to Las Vegas with their wad of hard-earned funds bulging in their pockets, fruits of their labors from toiling in the mines, mills, fields, farms and factories of this great land of ours. [Huh? Do we still have mines, mills, fields, farms and factories in this great land of ours? I thought we tore them all down and built condos instead.] Well, at any rate people go to Las Vegas with their pockets bulging full of plastic, and then they piss it all away at the slots or the tables or participating in the other ‘gaming’ activities. The monetary cycle goes straight from gambler to the House, with hardly any basic economic activity in between.
"Yes, gambling makes jobs for blackjack dealers, cocktail waitresses, slot machine repairmen and back-office accountants…Most gamblers need to sleep, so there are a few jobs for hoteliers and maids, and the kitchen staff who feed the hungry hopeful…eventually, gambling makes jobs for counselors who deal with gambling addictions, police officers who deal with vice crimes, insurance adjustors who deal with fraudulent claims, and Child Support staffers who deal with ‘failure to pay’-issues due to lack of funds…often as not, some bankruptcy attorney has the privilege of discharging the credit card debt. (If bank and credit card issuers were smart, they would restrict the use of their cards to ‘purchase’ credit and/or chips at gambling establishments, and limit their extension of credit for ‘gaming’ purposes. But they are not that smart…)
"If you sign a ‘marker’ at a gaming establishment, you had better read the fine print. You are probably swearing and affirming that you have sufficient net worth to honor the marker. And if you try, later on, to discharge the marker in bankruptcy, the House will file an adversarial action against you for fraud. (It takes huevos to try to discharge a gambling establishment – they have big guys with names like ‘Freddy the Torch’ working the collections…) But if you persist and go to court, you can settle the claim. Or you can explain to some federal bankruptcy judge why, on a certain date, you swore that you had sufficient net worth to pay off the marker. But on another date, you were filing for discharge. (‘But your honor, I lost all my other funds at the gaming tables, so that is why I could not pay off the marker…’)